Replacement Cost Valuation

Replacement cost valuation method is not very popular at stock valuation. Most of the investors are picking stocks with help of relative valuation or DCF valuation. Only when those two methods aren’t possible we should look at this one. Such situations may occur if there is no positive free cash flow (also future’s cash flow can’t be predicted) and there are no other similar stocks for comparison.

The key principle of replacement cost valuation is that costs required creating an alternative asset should be calculated. For example, if there is some new kind of a factory, but because of some reasons it doesn’t work at the moment (for example, it is just build and not yet opened) and there is no track record of similar businesses that would allow us to predict cash flows in the future. In such case we would use replacement cost method that would mean we should summarize the inevitable to build such factory: land, buildings, equipment, working capital, intangible assets and all the rest valuable assets. Stock of such company should be worth all that less net financial debt.

However, in practice all this is much more complicated, because even if replacement costs would be calculated very accurately it doesn’t mean at all that is correct market value. Might be that the object is not worth to replace. Maybe that object was a mistake, and nobody else would create it at that cost or buy in the market for that price.

Because of this disadvantage replacement cost valuation method is rarely used in real business. Mostly this one is used by bureaucrats or similar persons who need to show some specific value on their papers.

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